As Warren Buffett has famously said, “Price is what you pay. Value is what you get.”

The price of a particular stock is clear to anyone who cares to look it up. Just punch in the stock ticker symbol on a financial website, and you’ll see the current price instantly. Determining the value of a stock isn’t so simple. While a stock’s price is a simple fact, value is subject to interpretation and analysis. Differing opinions of value explain why the buyer and the seller can both walk away from a stock trade thinking that they got the better of the deal.

One simple metric commonly used to evaluate stock values is the price-to-earnings, or PE, ratio. You can use it with an individual stock, or expand it to look at the value of a group of stocks or stock market index such as the S&P 500.Figuring the ratioThe PE ratio is a simple ratio of a public company’s market price to its total earnings.PE = Market price/Net incomeYou get the market price by multiplying the number of outstanding shares of the company’s stock by the current share price. Net income is what’s left of a company’s income after all expenses and taxes have been paid. It’s profit, or the fabled “bottom line.”Let’s take Microsoft (MSFT) as an example. As I write this, the total public market value of Microsoft is approximately $373 billion. In the last 12 months, Microsoft earned $20 billion in net income. So the PE ratio for Microsoft is:MSFT PE = (Market price of MSFT)/(Net income of MSFT) = $373b/$20b = 18.7We can also express this on a per-share basis:MSFT PE = (Share price)/(Earnings per share) = 18.7The PE ratio is a shorthand way to express the value of a company. You can think of it as the price investors are paying for $1 of earnings. If you bought Microsoft stock, you would be paying $18.70 for every $1 of earnings.Some people like to invert the PE ratio, which produces a figure called the earnings yield.Earnings yield = (Net income of MSFT)/(Market price of MSFT) = $20b/$373b = 5.35%You could compare this to other potential investments, such as a 10-year Treasury bond, which currently yields 2.4%. Compared with the bond, Microsoft might be considered a good deal.Comparing companiesThe PE ratio also allows you to make quick comparisons between companies. For example, Adobe (ADBE), another software maker, has a PE of 128.5. Why would someone possibly pay $128.50 for $1 of earnings for Adobe, but pay only $18.70 for the same amount of Microsoft earnings? There are a host of reasons, and many relate to the possibility that in the future, Adobe will make much more money than today. Based on the PE of the two companies, it looks like market participants think it is much more likely that Adobe will continue to grow at a rapid clip compared with Microsoft.Stock ownership is a claim on the assets and income of a company — including future earnings — for as long as you own that stock. So if you think the company has good growth prospects, you might be willing to pay more to own that future income stream, which results in a higher PE.Finally, in addition to using the PE ratio to value a company, we can use the PE ratio to value a group of stocks or the market as a whole. If we think of the S&P 500 index as just one giant conglomerate with 500 divisions, then we can also calculate its PE ratio. In this case, the S&P 500 is currently trading around $2,080. This is the price of all 500 companies, weighted by their market capitalizations. The earning of all 500 companies for the last 12 months, weighted similarly, is $103. This produces a PE around 20.2. While this is much higher than the historical average PE for the market of about 16.6, it far below the peak of 46.7, reached in 1999.The PE ratio of the market is a good tool to give you a sense of historical valuation. The downside is that the PE ratio by itself does not have a great track record of being able to forecast future returns for stocks. Month-to-month and even year-to-year earnings tend to vary significantly because of unpredictable factors. As a result, there is very low correlation between the current PE ratio and future market returns. But don’t worry. Next time, we’ll look at PE’s big brother to help get a sense of how long-term returns might play out.

Disclaimer

Note: The contents of this site are general in nature and not intended as specific investment advice. All investments are subject to risk; including loss of investment value. If you have any question regarding investments or concepts in these pages, please consult with an investment professional.